Continue moderation in pace of tightening

This time it’s different, the refrain goes. In the Reserve Bank of India’s annual monetary policy statement for 2011-12, the spotlight on inflation will be much sharper than on others in the multiple indicators basket. The seeming lack of traction of the policy tightening will tempt a reassessment of the wisdom in continuing with baby steps, prompting a go instead for the economic jugular. This article argues for continuing moderation in the pace of tightening.

The main transmission channel for monetary policy signals is banks. The 200 basis points (bps) increase in policy rates last year, in conjunction with tight liquidity, resulted in a 400 bps increase in the cost of banks’ short term funds, which is being increasingly passed on to borrowers. One basis point is a hundredth of a percentage point.

Given the probable scenario of liquidity gradually tightening over the course of the year, the cost of banks’ borrowed funds is unlikely to fall in a hurry. Even without unduly adverse money market conditions, these costs will continue to increase as older, lower cost deposits keep getting re-priced. An inordinate increase in lending rates will choke credit to productive sectors of the economy at a time when infrastructure-related capacities need to be augmented. In any case, our current understanding of liquidity conditions makes FY12 credit growth much beyond 20% unlikely.

Then there is the nature of the current inflation. Rising prices are indubitably now spilling over into so-called core inflation. Yet, the dominant source of the current surge in inflation is, unsurprisingly, petroleum, manifesting in increasing prices of downstream derivatives. This is despite a visible slowdown in investment. In addition, while inflation is, in the long term, a monetary phenomenon, there is little evidence that excess liquidity is contributing to the current phase; for much of the previous year, M3 growth had been below the RBI target of 17%.

The global environment, too, is likely to come to India’s aid in the price battle. Inflation, in varying degrees, has become a global problem and central bank interventions are likely to result in some cooling off of prices, reinforcing the demand compression that high fuel prices will probably cause. Various structural weaknesses in developed market economies are also likely to lead to a slowdown later in the year. Many industrial commodities futures are already signalling this.

How best then to battle inflation? The most important thing is a coordinated approach among monetary, fiscal, industrial and natural resources policy authorities. Demand reduction must begin from energy usage, and for that petroleum prices must be the key signal; interest rates will be a second order, indirect and blunter instrument, imposing higher economic costs. An increase in petrol, diesel and other controlled petroleum product prices, even if moderated by cuts in duties, will lead to short-term pain, but will produce two outcomes. First, as a technicality, due to base effects, inflation in the following year will be lower.

Second, there will be demand compression due to an erosion of purchasing power. Most growth forecasts for FY12 have already been revised down.

Nobody thinks RBI should sit idly as high inflation sticks like a limpet to India’s economy. The issue is the speed and extent of tightening. The governor had earlier used a catchy aphorism to describe RBI’s monetary policy stance: festina lente (make haste slowly).

The tightrope in balancing inflation management while maintaining a modicum of growth would probably be best achieved in persisting with this view, using Chaucer’s exhortation: “He hasteth wel that wisly kan abyde.”

Saugata Bhattacharya is a senior vice-president, business and economic research, Axis Bank.